Working Capital Management for Startups: Optimizing Cash Flow for Growth

Working capital, which is defined as a startup’s current assets minus its current liabilities, is crucial for startups for several reasons. Essentially, it helps determine whether a startup can execute its growth plans or if it’s at risk of running out of cash. It achieves this by presenting an accurate forecast of daily operations and overall financial stability, allowing startup leadership to assess growth opportunities and supplier relationships in relation to the startup’s overall health.

Even if your startup experiences strong revenue growth, poor working capital management can undermine your operations before they even have a chance to get started. This post is designed to serve as a practical guide for startup founders on the importance of and best practices for managing working capital.

Understanding Working Capital Components

Before we get into the importance of managing working capital, it’s important to explore the basics. First, the formula:

• Working Capital = Current Assets – Current Liabilities

Current assets include cash, accounts receivable, inventory and prepaid expenses, while liabilities include accounts payable, accrued expenses, short-term debt and deferred revenue. You’d simply total up assets and liabilities, typically within 12 months, and follow the formula to calculate working capital.

Working capital can be calculated in dollar amounts and ratios. The dollar amount indicates the available funds for short-term purposes, while the ratio represents a proportion that divides assets by liabilities to provide a percentage-based comparison for evaluating financial health over time. Tracking these figures as key performance indicators helps leadership quickly identify trends and potential cash flow gaps.

Why Working Capital Management Differs for Startups

Working capital management can be a particular challenge for growing startups, as they often begin with a negative working capital balance. That’s not necessarily a bad thing for an early-stage startup, so long as they’re able to pay their short-term bills. However, as a startup grows and scales, rapid revenue expansion will also accelerate receivables and inventory needs, often faster than payables can keep pace. This makes fundraising cycles important for managing working capital in chunks rather than in steady cash flow and reinforces the need for efficient working capital management.

The Four Levers of Working Capital Optimization

There are four main levers of working capital optimization:

• Accounts receivable management
• Accounts payable management
• Inventory management
• Cash management

All are interconnected and important, and when they’re optimized, your startup can improve its cash flow, reduce costs and increase liquidity.

Accelerating Accounts Receivable Collection

How can your startup accelerate the collection of money owed by its customers and reduce days sales outstanding (DSO)? Strategies include:

• Negotiating payment terms: Consider implementing Net 15 for new clients or those with a history of late payments, and Net 30 for more established clients with a proven track record of reliable payment habits.
• Implement systematic AR management to automate invoicing and send automatic payment reminders when payments are 7, 14 and 21 days past due. You may also want to consider implementing payment escalation protocols that provide a clear roadmap to ensure the timely and effective resolution of payment issues.
• Offer early payment incentives: If consumers are incentivized to make early payments, they’re more likely to take advantage of any discounts or promotions. For instance, a 2/10 Net 30 offers a 2 percent discount if a consumer pays an invoice within 10 days of the date, but consumers must pay in full within 30 days if they pass the 10-day window.
• Consider AR financing, which utilizes unpaid customer invoices as collateral for a loan or by selling them to a third party to access immediate capital.

Optimizing Inventory Management

Optimizing inventory management can strike a balance between having enough stock to meet demand without overstocking. This can reduce cash tied up in storage and also reduce carrying costs. Strategies include:

• Calculate and work to optimize holding costs: Holding costs include warehousing, insurance and obsolescence risk and tend to account for 20 to 30 percent of annual inventory value.
• Implement just-in-time principles by utilizing demand forecasting to optimize availability and capital efficiency.
• Negotiate consignment or drop-shipping arrangements when possible.
• Use the inventory turnover ratio to help benchmark efficiency, which measures how often your startup sells and replaces its inventory during a specific period. Calculate it by dividing COGS by the average inventory for the period.

Extending Accounts Payable Strategically

Optimizing accounts payable should focus on managing payments to suppliers by negotiating favorable terms and ensuring timely payments. This can help with cash flow and maintain good supplier relationships. Strategies include:

• Negotiate extended terms, such as Net 45 or Net 60, with key vendors.
• Strategically prioritize payments: For instance, pay mission-critical suppliers on time and stretch discretionary spending accordingly.
• Avoid paying early unless you’re incentivized to do so. Paying on the deadline rather than early can help preserve working capital.
• Monitor DPO and track it to compare with industry benchmarks.

Industry-Specific Working Capital Strategies

Different startups with varying business models have distinct working capital needs, making industry-specific strategies a necessity. For instance, manufacturing or construction has longer production cycles and tends to require more working capital than those with faster inventory turnover.

SaaS Working Capital Management

SaaS startups have favorable working capital dynamics because they don’t have to manage inventory and operate on a recurring revenue model that often incentivizes annual prepayments with discounts, allowing them to access immediate cash. However, delayed revenue recognition can create a timing mismatch where costs are front-loaded and SaaS startups may have longer payback periods.

Strategies include minimizing AR exposure, automating payment processing, and being aware of customer acquisition efficiency to improve gross margins and shorten CAC payback cycles.

eComm and CPG Working Capital Challenges

eComm and CPG startups must manage inventory, delayed payouts and long payment cycles, which can create working capital challenges. Product launches require startups to invest in inventory months before they receive revenue, making inventory management a major challenge.

Strategies for managing challenges include optimizing payment processor timing, managing seasonal inventory by accurately forecasting demand to avoid over-purchasing and using purchase order financing to leverage confirmed orders to finance inventory purchases.

HealthTech and MSO/PC Models

HealthTech and MSO/PC models are mostly challenged by regulatory requirements and accounts receivable. For instance, insurance reimbursement can vary. Commercial insurance typically issues payouts within 30 to 60 days, while Medicare/Medicaid issues payouts within 45 to 90 days. There are also credentialing delays to navigate, which can range from 90 to 120 days before providers can begin billing. Any medical practice also requires capital for payroll and supplies.

Patient payment automation is one strategy to overcome working capital challenges. This involves collecting co-pays and deductibles at the point of service, rather than in the future.

Building a Working Capital Forecasting Model

Forecasting is essential for projecting future working capital needs and integrating results into your startup’s financial management. It’s also key for fundraising. Accurate forecasting requires modeling relationships between revenue growth and working capital needs.

The 13-Week Cash Flow Forecast

The 13-week cash flow forecast is the gold standard for managing near-term working capital, as the weekly granularity provides visibility into cash inflows and outflows beyond just monthly cycles. Structure your model forecast by operating cash flow, investing activities and financing activities. Weekly updates ensure a rolling forecast that maintains a constant 13-week forward outlook. A 13-week forecast also allows startups to model scenarios, such as best case, worst case and the most likely case to identify trigger points.

Working Capital Metrics and Benchmarks

Working capital metrics should serve as diagnostic tools to reveal whether working capital is improving or deteriorating. They enable startups to track trends over time and make adjustments as necessary. Some key KPIs include cash conversion cycle (CCC), days sales outstanding and days payable outstanding.

Cash Conversion Cycle

CCC is the master metric that synthesizes all working capital components. It measures the time it takes a startup to convert its investments in inventory and other resources into cash from sales. It’s calculated by using this formula:

• CCC = Days Sales Outstanding + Days Inventory Outstanding – Days Payable Outstanding

A low or negative CCC means capital cycles are fast and you need less working capital, while a high CCC could identify problems with operational efficiency. The ideal CCC varies across industries, so it’s best to compare your startup’s cycle with that of competitors or your own historical data.

When Working Capital Constraints Require Action

How do you know when working capital constraints are a problem and require action? Some key indicators are an inability to pay vendors on time, maxed credit lines and the inability to pursue growth opportunities. Proactive management can help resolve issues before they become major crises.

Short-Term Financing Solutions

Startups can rely on several short-term financing options for bridging any working capital gaps. These include:

• Revolving credit facilities: These are flexible lines of credit that allow startups to borrow money as needed, repay it, then borrow again up to a certain limit.
• Venture debt: This can help extend the runway between fundraising rounds.
• Revenue-based financing: This involves repaying a percentage of monthly revenue rather than a fixed payment.
• AR factoring: This involves selling outstanding invoices at a discount for immediate cash.

Partner With Working Capital Specialists

Ready to optimize your working capital with expert financial guidance? Graphite Financial’s Fractional CFO services are here to help. As a financial services firm that specializes in working with startups in SaaS, eComm and HealthTech, Graphite’s integrated approach mixes bookkeeping, financial modeling and strategic guidance to prioritize working capital management. Contact Graphite today for more information and to schedule a consultation.

FAQs

What is a healthy working capital ratio for startups?

A good working capital ratio that startups should shoot for is usually between 1.5 and 2.0. This range indicates that your startup has sufficient liquid assets to cover short-term liabilities, while maintaining a sufficient buffer to accommodate growth and any unexpected expenses. Ratios below 1.0 are unfavorable, while anything above 2.0 indicates that assets are likely being underutilized.

How much working capital should startups maintain as a percentage of revenue?

This largely depends on the industry, business model and your startup’s operational cycle. For instance, manufacturing or construction has longer production cycles and tends to require more working capital than those with faster inventory turnover. It’s more important to focus on a good working capital ratio, which should ideally be between 1.5 and 2.0.

Is negative working capital always bad for startups?

No, negative working capital isn’t always a bad thing. In fact, in some cases, it can be a sign of operational efficiency. However, if negative working capital results in your startup being unable to pay its bills, it should serve as a significant warning sign.

How does working capital management differ from cash flow management?

Working capital management involves striking a balance between a startup’s current assets and current liabilities. It helps measure short-term financial health and its ability to cover any immediate obligations. Conversely, cash flow management focuses more on the movement of money into and out of the startup over a specific time period. Cash flow management is a more accurate indicator of your startup’s operational profitability and its ability to generate cash.

What are the biggest working capital mistakes early-stage startups make?

Early-stage startups are prone to making several working capital mistakes, such as failing to manage cash flow, poor accounts receivable collection, high overhead costs and inadequate cash reserves. Other mistakes may include a failure to invest in the right financial tools, neglecting profitability and not securing sufficient financing.

How should startups prioritize working capital improvement—receivables, inventory, or payables?

Working capital improvement should be prioritized in the order of accelerating receivables, optimizing inventory management and then managing accounts payable. Startups can implement a variety of strategies to improve in these three areas, helping to shorten cash conversion cycles and build a more sustainable foundation for long-term growth.